‘What Output Gap?’

I have been more optimistic than most about the return to long-run trend, i.e. that the shock we experienced is mostly temporary rather than permanent, but here’s another view arguing that we have had a substantial decline in the natural rate of output:

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below “potential” GDP owing to “deficient demand,” the correct view? Or should we instead be thinking in terms of a large negative shock to “potential” GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a “permanent” (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called “output gap” (the difference between actual and “trend” GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed’s current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the “bubble period” as the economy being at, and not above, potential). Among other things, he says:

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

Precisely how such a policy “distorts fundamental decision-making” needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.

At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it’s shown that we shouldn’t grow complacent over what we think we understand.

I believe that costs are asymmetric — doing too little to help the economy is worse than doing too much — and the conclusion that the shock is mostly permanent rather than temporary is more likely to lead to policymakers giving up too soon (resulting in the more serious error). Thus, those that hold this view need to recognize the asymmetric nature of the mistakes they are likely to make and adjust their policy recommendations accordingly.

However, inflation hawks see the costs as more symmetric, and they are convinced the shock is mostly permanent, so they would disagree with the need to adjust their policy recommendations. But as noted above, I think the shock is highly persistent but ultimately mostly temporary, and I just don’t see the equivalence between a marginal increase in inflation versus a marginal decrease in unemployment. For me, unemployment is a much higher priority (and yes, I understand the argument that inflation problems ultimately impact employment).

Update: There are two concerns here that I may not have done enough to separate in the comments above. First, there is the concern that the asymmetric nature of the costs of inflation and unemployment is being ignored in policy recommendations (though, again, inflation hawks see inflation as more costly than I do, and hence see the costs as more symmetric, and they believe that a short burst of inflation to fight a recession is likely to lead to a long-run inflation problem — I have more faith in the Fed than that). This means, for me anyway, that policy ought to tilt toward unemployment (i.e., I disagree with Ben Bernanke’s recent assertion in testimony before Congress that inflation and unemployment should be and are weighted equally).

The second concern is the assumption that the natural rate has fallen permanently. Making this assumption when in fact the shock is largely temporary will lead to a miscalculation of the chance that we will face an inflation problem — the calculated odds will be too high — and the undue fear of inflation will cause policy to tighten too soon. This results in an error where unemployment rather than inflation is higher than desired. The opposite belief — the belief that the shock is temporary when it turns out to be permanent — leads to the opposite policy error, i.e. unemployment lower and inflation higher than desired, but to me that is more tolerable. That’s not why I hold the view it’s mostly a temporary shock — that’s a conclusion based upon economic considerations — but given that the costs are asymmetric the belief that the shock is temporary does result in a less serious policy error if it is wrong.

4 Responses to "‘What Output Gap?’"

burkbraun February 9, 2012 at 4:25 pm

This seems pretty nuts on the face of it.. how is having 10-20 million unemployed a "normal" long-run condition, wasting all that labor? Where did the bubble productivity / output come from, if not from employed labor doing normal things within the capitalist paradigm? Did that production come from Mars? If it was illusory bankster accounting, then that needs to be clarified.

Bullard seems to be making an ideological point, that unemployment is morally acceptable in the long term.

He is part of the Federal Reserve. Although the Fed has the two jobs of dealing with inflation and dealing with unemployment, as Robert Reich (or was it Krugman…sorry, it's been a while) pointed out, they usually only deal with the inflation part (unless the inflation is negative). Since it is likely that we are in a depression (in other words, wages are going down–whether we are creating jobs or not), the Fed can ostensibly focus on unemployment (they can't very well pay people to borrow money, so negative interest is a non-starter).

If and when inflation shows its head, you can bet that the bankers of the Fed will raise interest rates to ensure that we have no more than a 2% inflation–regardless of the unemployment numbers. After all, as far as the bankers are concerned, securing the money is far more important that unemployed people.

burkbraun February 9, 2012 at 4:43 pm

On reading the piece, Bullard seems to imply that the Fed's own measurement of GDP is inflated by the inflated housing prices. Firstly, this would not reflect well on the Fed's statistical procedures. More importantly, if the "production" part of GDP in the housing sector involves actually building houses, then the output gap is very clearly due to a lack of production of houses. If those not-built houses are not currently needed, then the labor used to build them would be available to do other things, again contributing to GDP.

The "bounce-back" that Bullard pooh-poohs is clearly the hiring of those unemployed workers to do productive things that contribute to GDP. Nothing more or less, and fully to be expected. Who educates economists these days?

Debts have been discharged historically in either (or some combination of) two ways: forgiveness or repayment with inflated money. By artificially keeping inflation at or near nothing while doling out a haircut or so to creditors (enabling them to ingest non-existent "potential return" over a protracted recovery time) which they will treat the same as the costs of utilities or postage, nominal expenses in the course of doing business, this zero-inflation policy is eating the seed corn.

"Income" is invariably conflated with "wealth" and as long as all eyes are on the former, the latter is getting depleted in the same way that oxygen gives out for anyone breathing in a closed space.